After declining nearly 15% in nine months, the dollar index looks ready to make a significant move up due to several technical and fundamental factors.
First, the dollar index held a long-term trendline of support last week as shown in the chart below () and this “hold” may suggest that the dollar index is set to bounce up and off of it in the coming weeks.
Second, the dollar index is caught in a long-term Symmetrical Triangle pattern and this is shown in the same chart. While it’s unknown whether the dollar index will break to the upside or downside from that triangle, it seems pretty clear that the dollar index needs to fill in the rest of this pattern’s nose before such a break can be made and this suggests that the dollar index will move to at least 85 in the coming months while a spike even higher is also possible.
Third, the main component in the basket of currencies against which the dollar is measured for the dollar index is the euro (58%) and the euro has been riding strong this year on the hawkish stance of the European Central Bank. In fact, the euro spiked above $1.40 last week with the ECB’s hinting of a possible rate hike in April.
This type of tough talk against possible inflationary forces from Mr. Trichet clearly provided the spark for that spike but investors seem a bit less awed this week either by the fact that the peripheral euro-zone nations are less likely to handle a possible rate hike well or that a rate hike in April may backfire as the ECB’s last rate hike made back in July 2008 turned out to be.
Fourth, the euro’s weakness this week also reflects investor concerns around the sovereign debt crisis deepening with the some of the euro-zone nations and banks facing further liquidity and solvency issues.
The bond vigilantes are clearly sending this message with the 5-year yields on Portuguese (red) and Irish (green) debt at 2011 highs as shown in the charts below () while the Greek 5-year yield is currently at 14.625% and well above this year’s low of 11.75%.
In addition, interbank lending conditions have worsened as shown by the rise in Euribor in the chart below.
Lastly, nerves seem to be increasing around the upcoming European bank stress tests and the fact that such tests will be seen as another farce and similar to view on the bank stress tests from last summer with certain banks passing only to be bailed out by tax payers months later.
Of issue this time around is the fact that individual countries will have the ability to set the Tier 1 capital ratio for its banks such that there is not a uniform standard by which to measure the 88 major banks tested while some of the stressful conditions that the banks are to be tested under are not particularly stressful.
Irrespective of what the problems are to plague Europe in the coming weeks and months, the chart of the EURUSD suggests such problems will come to the forefront with the EURUSD caught in a bearish Broadening Formation as shown below ().
This particular pattern carries a target of about $1.28 and such a potential decline will break a long-term trendline of support (not shown here but it can be viewed at peaktheories.com) and this will weaken the EURUSD’s prospects from a technical perspective considerably.
Fifth, I think there’s some evidence that the Federal Reserve may begin to back away from its bond buying activities while it seems even more likely that it will not initiate a new round of bond buying. I believe this to be the case because the current economic recovery has been engineered, largely, by the Fed’s liquidity efforts but such efforts have done nothing to improve the all-important velocity of money.
As a result, I think we may begin to see the Federal Reserve steer investor and public perception toward a strong dollar, rising rates recovery and the sort that will last and should such steering – or communication – occur, it will be the very thing to strengthen the dollar on its own merits.